Activity Based Costing (ABC): Easy as 123?

Banks have had a tough decade. With deflated interest rates, ballooning compliance costs, and growing geo-political tensions, it’s no surprise that returns in the banking industry have not sprung back to pre-2008 peaks.

Financial performance in 2018 was particularly glum for European banks. Declining revenues contributed to low returns, reflected by share prices falling an average of 25% year on year¹.

But in the struggle for improved returns, revenue is only one half of the equation. Banks also need to optimise their cost base to boost profitability. And to optimise anything, you must first truly understand it.

With that in mind, many banks are looking towards activity-based cost allocation methodologies to:

1. Better understand the cost base of back and middle office functions by documenting the activities they perform in ‘Service Catalogues’
2. Transparently allocate the costs associated with these activities to front office departments based on documented and agreed ‘cost drivers’

However; implementing these changes is not without its challenges, and organisations should consider several fundamentals before ‘taking the plunge’.

First, defining an exhaustive catalogue of all services performed by back office departments is a time-consuming and extensive exercise. Leveraging existing service-oriented views of the bank or an industry standard as a starting point can provide a shortcut – but will only get you so far. There’s simply no way round speaking to those performing the services to get Service Catalogues right.

Second, other processes within the bank require similar taxonomies of services performed within the organisation, for example transfer pricing and living wills. This can cause confusion if ‘multiple versions of the truth’ exist, which can be time consuming to reconcile. Aligning Service Catalogues across similar processes reduces complexity and can allow the integration of these processes in the longer term. It’s also critical that Service Catalogue change control and governance procedures are enforced to ensure there is only ever one version of the truth.

Third, selecting the ‘right’ version of the organisational structure to use for allocations and agreeing this upfront. For example, organisations may choose to allocate by business, by segment, by product, by legal entity, by geography, or by a hybrid of one or more of the above. Preferably, organisations should select the view aligned to that which is used to produce internal financial MI, to support management decision making using the final outputs of the allocation process. Not agreeing the preferred organisational structure up-front can cause problems later in the implementation when agreeing how and who to allocate costs to and from. There must be an agreed view which is stable and change controlled.

Linked to this, a significant challenge for many organisations is availability of accurate cost data at the level which the organisation would like to allocate the costs from. For example, if costs are being allocated using a geographical view of the organisation, the organisation must have confidence that cost data at the lowest level to be allocated from (e.g. region, country, city) is both available and correct. Investment to improve the accuracy of cost data may be needed, and any remedial activities should take place within source Finance systems, rather than at the point of allocation, to ensure traceability of the data back to its source.

Data is again a challenge during the selection of drivers, which are used to calculate what % of each service cost should be allocated to each receiving area. Drivers should ideally be selected based on their suitability to reflect the ‘need’ for the service from the receiving area. For example, the driver for an ‘invoice processing’ service may be ‘# of invoices’. Agreeing these drivers conceptually may be relatively straightforward, but again, the key question is data availability. If the organisation wishes to allocate to a very low level within the organisation (e.g. cost centre), they will need to ensure that driver data is available at that level. Drivers selected for their conceptual fit will often be discarded due to a lack of data availability, and a different, higher-level, proxy driver (e.g. FTE, revenue) may be used.

Utilising less conceptually clean drivers can subsequently lead to more fundamental problems.

Selecting drivers that reflect the ‘need’ for the service by the receiving area enhances cost transparency and incentivises the front line to change their behaviour to reduce the amount they are charged. However, where a less clean approach (e.g. proxy drivers) is used, it not only removes the direct cost-to-consumption link, it can also drive the receiving areas to focus on changing the selected drivers to reduce only their share of the pie, rather than actually changing their behaviour and helping to reduce cost.

Early engagement of senior leadership in both the back and the front office, and consistent messaging from management regarding cost discipline, should help retain the focus on overall cost reduction, rather than reducing individual areas’ share.

Finally, choosing a method for sequencing the allocation of costs by area can be a challenge. Most banks pursue a form of ‘waterfall’ methodology, choosing a logical sequence for allocation of costs between different areas of the bank aimed at minimising the potential conceptual need for ‘backward’ allocation of cost. Many banks tend to allocate Corporate Real Estate (CRE) and IT costs to other back office functions first, before the other back office functions allocate their cost base, including those costs received from CRE and IT, to the front office, without being allowed to allocate ‘backwards’ to CRE and IT. Different sequencing methodologies will be suited to different organisations, but the bank must select the most appropriate one for its own use, balancing considerations of complexity and accuracy.

To conclude, most banks recognise the need to better manage their costs to achieve their targeted returns, and activity-based costing methodologies can be a powerful tool in this journey.

The first step is understanding the challenges with these approaches, and overcoming them by:

– Defining Service Catalogues in collaboration with the back office
– Aligning the Service Catalogue to other similar taxonomies (e.g. Transfer Pricing)
– Agreeing which view of the organisation to use for cost allocations
– Confirming the accuracy and availability of cost and driver data, and investing in improvements where needed
– Selecting drivers that truly incentivise cost reduction, and reflect the need for the service
– Choosing a method for sequencing cost allocations that balances complexity with accuracy

By addressing and overcoming these challenges up-front, banks can use activity-based costing as a powerful tool to drive cost reduction. Ultimately, that’s what it’s all about.

References

¹ https://www.ft.com/content/79352980-0463-11e9-9d01-cd4d49afbbe3